Trader’s Narrative

Yesterday we looked at what happens when the S&P 500 is this far above its long term moving average. If you haven’t yet read that, click on the previous link and read it first because then what follows will make much more sense.

As you’d expect, when the stock market is stretched 20% or more above its 200 day moving average, it has a hard time continuing such a heady move. Instead, we find that the market pauses or retreats in the short term (1 to 3 months). But as Barry pointed out in the comments, there is a difference to how the market behaves in a bear market rally and a real secular bull market. With that in mind let’s analyze the data further.

If you looked at the historical data table that I showed outlining the previous extremes you probably noticed that 4 out of the 13 instances occur very close together in late 1982 and early 1983. This was, of course, the launch pad of the super bull market. The S&P 500 closed at 102.84 on August 10th 1982 and never looked back.

So naturally, there is a cluster of data points (chart below) as the market went on a rampage. This also explains why the 6 month period returns are so inordinately high:

That’s a lot of red marks! Between January 1st, 1980 and June 30th, 1983 there were 28 days when the S&P 500 was above its 200 day moving average by at least 19.5%.

If you look at the chart carefully, you’ll notice something remarkable. Even in such a super-strong bull market, this simple indicator is still able to identify short term tops in the market. But in the intermediate term, the market simply ignored any and all overbought signals. And eventually, by May 1983, they were’nt even able to mark a teeny bit of a correction. After all, in a strong bull market, ‘overbought’ is meaningless.

The question then is, are we about to see something similar? That is, do bull market rules apply? will this most recent extreme be simply the first of many? will the stock market simply ignore each and every one as it goes on yet another rampage the way it did in 1982?

No one knows of course. But personally, I think such a scenario to be highly improbable. It just wouldn’t make sense to expect a repeat of the 1982 experience. For one, we do not have the volume to fuel such a move. Second, and most importantly, we do not have the valuation.

I know, I know, fundamental analysis is for chumps. But I’m not talking about trying to game next quarters earnings estimate. I’m referring to the aggregate valuation of the market. Something for which we have much evidence to indicate excellent predictive value in the long term. For details, I refer you to Shiller’s excellent book: “Irrational Exuberance“.

Let’s pretend to ignore that the market has never rallied 60% in 6 months before. Let’s also ignore that never before has it performed even remotely close to that when the unemployment rate was this high. And ignore that corporate insiders are selling like lemmings. That sentiment is way too optimistic. That 95% of issues closed above their 200 day moving average (and 93% above their 50 day moving average). Even if we brush all of that and more under the rug, we can’t ignore how expensive the market is here:

• the trailing P/E (for operating earnings) is 26
• at the onset of the bear market in October 2007, it was 19
• the trailing Price Earnings ratio is 184 (reported earnings)
• on October 2007 it was merely 23 (in October 1987 it was just 20)
• the price to dividend ratio (click for chart) is at 53
• on October 2007 it was 55 and way back at the start of the super bull (1982) it was 16
• based on one year forward (operating) earnings the P/E ratio is 16 - highest in 5 years
• on October 2007 the forward est P/E was 14 (same as on Oct 1987)
• Price to Book ratio is 2.3 - August 1982 it was below 1 (discount to book)
• based on recent Tobin’s Q analysis, the market is 40% overvalued

While the market is a forward discounting mechanism, there is a limit to how much and how far ahead it can do so. Arguably, at these prices, the stock market is discounting the next 3 years operating earnings (2012). Historically, the market faces strong headwinds when P/E reaches 25. The average 1 year return at that valuation (or higher) is -0.3%. (All valuation data sourced from David Rosenberg’s invaluable research at Gluskin Sheff).

All of the above leads me to conclude that the most apt script is the one we’ve seen before many times in the aftermath of secular bear markets. While the performance of the stock market since March has been more than impressive, the stage is not otherwise set for the launch of a secular bull market.

Last month we looked at a simple method for valuing the market called Tobin’s Q. (To get details, check the previous link).

Working with the available data we had back then we surmised that the market had gotten much cheaper but that it was still not quiet at a level which had historically marked bear market bottoms. But using the forward estimate of a Q ratio expert (the most preeminent disciple of Tobin) we were expecting to find a flush down in the first quarter of 2009 taking us down to that level.

The Federal Reserve released its data for the first quarter of 2009 and unfortunately the estimate by John Mihaljevic was not borne out. This bear market is not finished - at least not according to Tobin’s Q ratio.

I’m not really sure how the eggheads at the Fed actually crunch the numbers for the numerator and the denominator but adjustments are the norm. Each quarter we not only have new data but usually small adjustments are made to prior numbers.

This most recent data release was no different with almost all previous data points changing slightly. For example, the 2008 fourth quarter data changed from 0.6208 to 0.6730. The only (thin) silver lining in this cloud is that we are continuing to head in the right direction: lower. But in order to give us a signal, the ratio has to fall precipitously to the 0.40 level. Which is not to say that it can’t do so.

In the first quarter of 1974 the Q ratio was 0.58, not far from where we find it now. During the next few quarters, it fell so fast that by the fourth quarter of 1974 it was 0.33 - at an extreme historic low, signaling a generational opportunity in the equity markets. You can mouse over the chart below to see what I mean.

By the way, if you haven’t yet, I highly recommend picking up a copy of Valuing Wall Street. It is the definitive book on this indicator and at only $10 even a cheap bastard like me can’t resist it. A little trivia: this book came out at the same time as “Irrational Exhuberance” but either because it had a useless publicist or because the concept was too dry, it never got the same traction as Prof. Shiller’s book - even though it argued correctly that the 2000 market was about to take a massive tumble.

You can get the most recent data as well as the archived files at this Federal Reserve page.

There are many different ways to value the stock market. We are waiting for the Coppock Guide to give us a signal by month’s end (just a few more days left). The usually reliable price earnings ratio has gone haywire, but the dividend yield ratio is still valid.

But what if I told you there is an even better way to sum up the valuation of the stock market in just one number? A method that is both rational and comes with an astonishing track record, having identified every single generational buy opportunity?

Tobin’s Q was created by the late James Tobin, a pre-eminent economist and professor at Yale. His work garnered him a Nobel prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.” But he’s probably best known for his work on the stock market. Put simply, Tobin’s Q is a ratio of the current value of the market divided by the replacement value of those same assets.

Think of a factory. It has a market price at which it would be bought and sold. And it also has a replacement cost - what one would have to spend to rebuild it from scratch. The ratio of the two is Tobin’s Q. Obviously, that would imply that when the ratio is greater than 1 the market is overpriced because one could theoretically ‘rebuild’ it for a cheaper price than it would take to purchase it. The Q ratio for US equities has fluctuated between 0.3 and 3 in the past 130 years.

It has signaled all the great bear market lows: 1982, 1974, 1949, 1932, 1921. Tobin’s Q moves at such a glacial pace that other indicators - even the Coppock Curve - seem twitchy by comparison. But when it does approach an extreme, it pays to give it the respect it deserves.

The best book on Tobin’s Q is Valuing Wall Street by Andrew Smithers (of Smithers & Co.). It came out at the same time as Shiller’s more famous Irrational Exuberance.

Both books had the same message and both were published at the exact peak of the 2000 bubble, but Shiller’s work got more attention because it was written to be more accessible to the general public while Smithers is more targeted to educated traders and investors. Although both books are good Shiller’s book stole much of Smithers’ thunder. You can pick up a copy from Amazon for less than $4 - which is a steal really.

As you might imagine, calculating the replacement value of such a diverse set of ever changing assets is mind bogglingly complex. Thankfully, the Federal Reserve does the heavy lifting. They provide the data in the Flow of Funds Report (pdf document). Look for the numerator on B.102 line 35: Market Value of Equities Outstanding (on page 103) and the denominator: Net Worth on line 32 (same page).

So the ratio resolves to:

9554.1 ÷ 15389.8 = 0.6208

Due to the nature of the data, it is only available quarterly with a lag of a few months. The latest report was released March 12th, 2009 which means the above number is for the fourth quarter of 2008. We should be getting the release of data for the first quarter of 2009 soon. But some analysts also guesstimate the number ahead of time. John Mihaljevic, the former research assistant to Tobin says the current value of Q is around 0.43 - which would be extremely close to the historic low of ~0.30. Following the previous link, you can not only get further details but purchase his complete report.

Obviously the market could fall more and take the Q ratio down with it. But this is further evidence that we are much, much closer to a generational buy point here rather than somewhere along the line of a continuing downtrend. Similar to the Coppock Curve, the Q ratio is not only setting up for a bullish signal but one of epic proportions.

Here is a chart of the Q ratio (from 1952 onwards when Federal Reserve data is available):